How Employer-Sponsored Insurance Drives Up Health Costs

In 1942, Franklin Delano Roosevelt signed the Economic Stabilization Act, which exempted health insurance from its mandated wage controls: the original sin of America's flawed health-care system. (Photo credit: Wikipedia)

A new study in Health Affairs is attracting attention for its depiction of how powerful hospitals are extracting “steep payment increases” from insurers. But what the study really tells us is how much the exceptional cost of American health insurance is caused by our system’s original sin: the fact that, due to a quirk in the federal tax code, most of us don’t buy insurance for ourselves, but instead have it bought on our behalf by our employers.

“In the constant attention paid to what drives health costs,” the authors begin, “only recently has scrutiny been applied to the power that some health care providers, particularly dominant hospital systems, wield to negotiate higher payment rates from insurers.” If you’re a regular reader of The Apothecary, you know from where some of that scrutiny has come. And hence, you won’t be surprised to learn that the Health Affairs study does indeed find that powerful hospital systems have the power to dictate prices to insurers.

"Must-have" hospitals possess pricing power

There are some predictable nuances to the authors’ findings, which are based on the Community Tracking Study from the Center for Studying Health System Change. (The study’s lead authors, Robert Berenson and Paul Ginsburg, hail from that institution.) The authors found that top-tier, “must-have” hospitals had the strongest leverage over insurers. These are the brand-name hospitals, like Harvard-affiliated Partners HealthCare in Boston, that insurers have a tough time leaving out of their provider networks. Second-tier hospitals that provide unique services, like organ transplantation, have some leverage over insurers, but not as much as the “must-haves.”

Insurers have been responding to hospital consolidation with their own. In many areas, a single carrier—often Blue Cross Blue Shield—has dominant market share, which, in theory, allows the insurer to compensate for hospitals’ market power. But a secondary finding of the Health Affairs study—and, arguably, its most important one—was that these dominant insurers were not using their market power to get tough with hospitals.

“Even in markets with dominant Blue Cross Blue Shield plans—in our sample, these markets included Boston, Greenville, Indianapolis, Little Rock, Lansing, and Syracuse—respondents thought that hospital negotiating strength was growing. Perhaps more important, dominant Blue Cross Blue Shield plans were perceived as not using all of their potential bargaining power.”

Why is it that these dominant insurers are rolling over when powerful hospitals demand higher prices? It’s quite easy to explain.

Fourth-party insurance is worse than third-party insurance

The fundamental cause of this problem is the fact that only 10 percent of Americans with health insurance buy it for themselves. Due to an artifact of World War II-era wage controls, if employers take money out of your paycheck and use it to buy health insurance for you, you don’t pay income or payroll taxes on those funds. However, if you decide to buy insurance for yourself, you have to do so with after-tax dollars. As I described in a 2010 article for National Affairs, this quirk gives employers a “major incentive to provide generous benefit packages.”

For example, a worker who pays federal and state income taxes at a combined rate of 30% will receive $7,000 for every $10,000 his employer provides in gross salary. But the same employee will receive $10,000 in benefits for every $10,000 his employer spends on health insurance—a 43% improvement.

Stanford Nobelist Kenneth Arrow famously described third-party insurance as one of the principal flaws in America’s health-care market. That is to say, because patients don’t pay for their health care directly, they’re insensitive to the cost and value of that care. But the 155 million Americans with employer-sponsored insurance in fact have fourth-party insurance. Not only do they not directly pay for their care, but they don’t directly pay for their third-party insurance.

It is, therefore, no surprise that insurers cave in when hospitals demand higher prices. Workers have no idea what their employers spend on their health plans, and therefore get upset when their employers buy insurance that doesn’t provide access to brand-name hospitals. “Of critical importance [to increased hospital leverage] was employer resistance to choice-limiting networks with few providers,” write the Health Affairs authors.

If you fly from time to time, you’ve noticed that airlines have started charging for various things that used to be "free:" baggage handling, say, or in-flight dining. Many people used to the old ways complain about this, but airlines consistently find that consumers prefer lower fares to cost-inefficient, and tasteless, airplane food.

No such price signal exists in the employer-sponsored insurance market. If you bought insurance for yourself, you might be quite willing to accept health care from the “second-tier,” but reputable, hospital if it meant that you could save 30 percent on your premiums. But while you know how much you make each month in salary, you likely have no idea how much your employer pays each month for your health insurance.

The economic costs of demonizing insurers

Another, related problem, is that the left demonizes private insurers. In their eyes, the reason health care is so expensive is because these insurers supposedly jack up premiums in order to rake in ungodly amounts of “profits.” (Never mind that insurer profit margins are typically 5-6 percent, and that many private insurers are actually non-profit entities.)

Attacking private insurers also serves a political purpose, by giving progressives a rationale to replace private insurers with government-run health care. (Let’s leave aside the question of whether government-run entities are usually more consumer-oriented than private ones.)

But this political climate—in which insurers are the bad guys, and hospitals are the heroes—does a lot to drive up costs. Insurers know that they will be portrayed badly in the press if they stand up to popular, brand-name hospitals. “There is a dynamic in the market that makes it impossible for a private payer to change anything,” a Boston respondent told the Health Affairs authors. “They [the insurers] never recovered from Tufts [Health Plan] trying to take on Partners and getting beaten down. It scared everyone off…It showed that employers would not support plans in showdowns against hospital systems.”

A 2001 article from HSC describes the ill-fated showdown between Tufts Health Plan and Partners HealthCare, the hospital chain formed from the merger of Massachusetts General Hospital and Brigham and Women’s Hospital in Boston. “As the impasse played out in the media,” the authors write, “consumers and physicians flooded Partners and Tufts with phone calls expressing concern about losing access to Partners’ providers.” Eventually, Tufts caved in:

Partners HealthCare System and Tufts Health Plan announced a parting of the ways in October 2000. Although they eventually came to terms, more than three months of contentious contract negotiations took a toll. Tufts and Partners—which includes the renowned Massachusetts General and Brigham and Women's hospitals and more than 4,000 affiliated physicians—were unable to agree on payment rates. A contract termination could have caused an estimated 100,000 people to lose access to Partners' hospitals unless they selected another plan that included the hospital system in its network.

Claiming they had lost $42 million in treating Tufts' enrollees in the previous two years, Partners argued it could no longer accept payments that did not cover the system's costs. According to local news reports, in initial negotiations with Tufts, the system demanded a 29.7 percent increase over three years, or 9.9 percent per year. Partners' previous success in gaining a double-digit payment increase from Blue Cross and Blue Shield of Massachusetts, the largest Boston health plan, also emboldened the hospital system.

Tufts counteroffered with a much smaller increase. To meet Partners' demands, Tufts contended it would need immediate premium increases of 20-25 percent, threatening a loss of business the plan could not afford. In addition to rising medical costs, the plan was recovering from significant financial and membership losses, largely because of an ill-fated regional expansion strategy in the late 1990s.

However, Tufts faced pressure to return to the negotiating table. The timing of Partners' contract termination during Tufts' largest annual open enrollment period left the plan at a disadvantage, because it opened up the possibility of large-scale enrollment shifts if people wanted to maintain access to the Partners system. Moreover, as the impasse played out in the media, consumers and physicians flooded Partners and Tufts with phone calls expressing concern about losing access to Partners' providers, while local employers pressured the two sides to come to some resolution. The state attorney general, though limited in authority to intervene, sent a letter urging the two sides to resume negotiations and avoid disrupting consumers.

Shortly after Partners broke off negotiations with Tufts, the plan attempted to contract directly with some of the large physician groups affiliated with the system. Physicians decided it was in their best interest, however, to remain aligned with the hospital system. With few remaining options, Tufts resumed talks with Partners one week after Partners broke off negotiations, and the two sides settled on a contract several days later. While neither side would disclose specifics, Tufts confirmed the deal contained significant payment increases.

The compelling solution: reform the employer tax exclusion

The solution to this problem is, from a policy standpoint, simple: equalize the tax treatment of individually-purchased and employer-sponsored health insurance. If more people bought insurance for themselves, more people would understand the tradeoffs between higher prices and access to brand-name hospitals. Those “must-have” hospitals, in turn, would be more reluctant to exploit their market power to raise insurance premiums. And insurers would, in turn, have more ability to walk away from pricey hospitals, instead of rolling over and passing those costs onto their policyholders.

While such a reform would be legislatively simple, and enjoys wide consensus among economists from both sides of the spectrum, it won’t be politically easy. Most people are happy with their current insurance arrangements, precisely because they aren’t aware of how costly they really are. That’s why President Obama promised, inaccurately, that, under Obamacare, “if you like your insurance, you can keep it.”

In addition, lots of industry stakeholders are happy with the status quo. Hospitals like it, because it gives them carte blanche to raise prices. Insurers are okay with it, because the current arrangement reduces competitive pressures for those incumbent plans with huge market share. And many businesses like it, because employer-sponsored insurance creates the phenomenon of “job lock.” It’s harder for workers to leave their jobs for better ones, especially if they fall ill on the job and risk being forced to pay for costlier insurance at their next employer.

Hence, any attempt to reform the employer tax exclusion will face immense political pressure. But that short-term political pressure is nothing, compared to the long-term political pressure that the private sector will endure under the status quo. For, as insurance gets more and more expensive, and more and more Americans are priced out of the system, calls for socialized medicine will grow louder and louder.

The best thing about Obamacare is that the debate around the program has brought considerable attention to the real problems facing our health-care system. That political window will not last forever. For market-oriented health reformers, it’s either now or never.